Don Coxe On Everything From The Markets Rolling Over, To Persistent Food Inflation, To The Coming US Sovereign Debt Crunch

There is a plethora of original insight in Don Coxe (BMO Capital Makets) among them observations on sovereign risk moving from east to west, state finances (or lack thereof), the ongoing correction in financial stocks which portends nothing good for the equity investors, the ongoing violence in MENA, why this inflationary spike in food may last far longer than previous ones, and naturally, some very spot on thoughts on gold, which conclude with: "The only gold bubble likely to burst is the bubbling ridicule of gold."

On sovereign risk migrating:

Sovereign Risk Moves West

The Eurozone's problems are not the only existential challenge to the Capital Asset Pricing Model: the bonds at the very base of the risk-free classification in the Model—Treasurys—have come under critical concern since it began to appear that the record-breaking US fiscal deficits won't be seriously addressed as long as investors can be found somewhere in the world prepared to buy Treasurys. Lots and lots and lots and lots of Treasurys.

When Obama's State of the Union speech included no budget proposals apart from the hoary pledge to control costs and waste, and when the Obama budget that followed included no provisions for dealing with entitlement programs—and included higher pay increases for government employees than some analysts had expected, bond managers globally began voicing concern—and selling the dollar.

Fortunately, there was a buyer of fi rst and last resort—QE2, as traditional buyers were gagging.

China reduced its Treasury purchases, Bill Gross announced he was not just out of Treasurys—he was short—and then S&P announced that, if Washington didn't do something soon about its multi-trillion-dollar deficits, the US would lose its AAA rating.

In one sense, a downgrade from S&P should be no problem for the USA: what credibility can one assign to such ratings? S&P and other ratings agencies happily assigned Treasury-equivalent ratings to more than a trillion dollars in putrescent derivatives issues masquerading as desirable mortgages. That the raters remain in business at all is a demonstration of Mr. Bumble's expostulation, "The law is a ass!" Friendly judges have dismissed lawsuits against the rating agencies—who were paid far more than their services were worth for saying that the mortgage products they were examining were worth far more than they were worth.

The judges accepted the ratings agencies' arguments that penalizing them for exercising their opinions would unconstitutionally penalize their right to free speech. It turns out that free speech that doesn't come for free, but for fat fees, is as worthy of Constitutional protection as—we were going to say quoting the Bible in public, but that might get an American into real legal trouble these days. As a colleague remarked, “If a doctor sent you for an MRI, and it revealed four tumors, and he didn’t tell you, you or your heirs could successfully sue him. What’s the difference?”

So, according to a series of court decisions, demonstrating, on majestic scale, something between outright sloppiness and outright venality—that was a major contributor to the worst fi financial crash since the Depression—is protected behavior. Those who relied on those fee-for-service appraisals and then lost hundreds of billions go uncompensated. The investment banks who peddled the putrid products with the AAA ratings haven't been forced to recompense their clients, the Congressmen who used their full power of office to force banks to make loans to borrowers who couldn't service the debts haven't been voted out of offi ce, and now the rating agencies have been given a pass by the courts.

So nobody—not bankers, not politicians, not raters—is legally to blame for the disaster which has already added more than $2.5 trillion to the national debt.

If no Americans are to blame for a financially-caused global recession that began in the US, why should overseas investors trust the US to remain the world's best credit?

We believe it highly probable that the US's fiscal problems will not be seriously addressed for at least two years, and that Obama will be resoundingly re-elected in a campaign demonizing Republican budget proposals. All polls show that most Americans believe the deficits can be eliminated without any cuts in Social Security or Medicare.

We would expect that, in a year or less, long Treasurys will trade at higher yields than many high-grade corporate credits.

In other words, we believe the Capital Asset Pricing Model is being driven into a ditch by reckless governments on both sides of the Atlantic, and that means endogenous risk within pension funds could be much higher than trustees realize.

On gold:

Some Thoughts on Gold

There is a new torrent of warnings of a "gold bubble."

We have been hearing that story from concerned clients, partly in response to George Soros's highly-publicized liquidation of his holdings of the gold ETF: GLD.

Another factor has been the debate about Barrick's move into copper, which is being partially financed by a large bond issue. Despite Peter Munk's passionate and articulate defense of that strategy at Barrick's annual meeting, many observers seem to wonder whether this is a warning sign from the long-standing pre-eminent gold miner that gold's future is problematic.

The financial press has been including many sneering observations that gold is a useless speculation on infl ation that is unlikely to occur. Why own an inflation hedge that pays no income?

We dissent from that tiresome scorn: those trained in Keynesian economics about the "barbarous relic" never bother to reflect that Keynes expressed almost childlike faith that central banks, acting pursuant to the Bretton Woods agreement of which he was a major architect, would always exercise restraint in monetary policies that would make gold passé.

The Seventies proved him horribly, hopelessly wrong.

But the Eighties and Nineties made it look as if he would ultimately be proved right.

However, the history of major monetary policies since then—and particularly since 2007—makes the case for gold appears as cogent as it was in the Seventies. This time, there’s no chance the Fed will drive interest rates to double-digit levels to fi ght infl ation and protect the dollar. It may be that, after years of getting by on Financial Heroin, the economy lacks the energy and élan vital to survive even normal interest rates—let alone Volcker rates.

As for the most basic argument—that gold is not an investment, because it pays no income—that seeming tautology is, at root, inherently false.

Gold has always been an alternative currency. It is resuming that role as central banks switch from the sell to the buy side.

A unit of paper currency pays no income.

It can be exchanged for bonds, deposits or stocks that pay income, but a holder of a million euros or dollars in a safe deposit box earns no income on the hoard—just as a holder of a million dollars' worth of gold earns no interest.

The big difference is that the inherent value of the paper euros or dollars will fluctuate in response to the changes in those currencies' values against other forms of paper money, and all currencies must decline in purchasing power inexorably in response to longer-term infl ation. According to our favorite skeptic on Received Wisdom, Stephanie Pomboy of MacroMavens, the S&P's performance since 2000 defl ated by the gold price move in that time is a minus 82%, compared to the more reassuring nominal return.

Leading central banks now target infl ation at 2%, saying that anything less could lead to defl ation and Depression.

As Harry Truman, one of the most shrewdest and most candid of Presidents, observed in response to Keynesian demands that the US target an "acceptable" rate of infl ation that would do no harm, but would be economically stimulative.

"You can't. That's like being a little bit pregnant."

Gold's market value most certainly fluctuates. But so does the purchasing power of paper money. Its inherent value almost never rises, but its slow decline can seem almost imperceptible. However, if commodity-spawned inflation comes roaring back, paper money’s value will plummet.

With global money supplies growing at cancerous rates, this would not seem to be a propitious time for sneering Keynesians to dismiss gold's rise as "a bubble." How many of them warned that the Japanese bubble, or tech bubble, or housing bubble would burst with disastrous consequences?

Why do they argue that there will be no inflation from Fed and Bank of Japan policies—for which there are no precedents, and which make Seventies central bank policies look almost as tight-fisted as Paul Volcker?

Gold has—for millennia—been the one commodity that can always be used to buy other assets or goods and services.

It will always have that basic—and completely useful—function.

The only gold bubble likely to burst is the bubbling ridicule of gold.

On MENA:

The current equity selloff is not just driven by disturbing economic news in the US and Europe and a slowing in China’s growth rate. There is disappointing geopolitical news:

1. The Arab Spring that was evoking such joy when we published our last issue has turned into a hot, hate-fi lled summer.

2. In Egypt, which was the scene of some of history's most moving displays of liberal revolution since the Fall of the Wall, many Coptic Christians are being murdered, and their churches are being torched. The Islamic Brotherhood, which delighted so many pundits abroad by promising not to offer a candidate for the Premiership, now promotes one of its conservative elitists for the top job; it is widely agreed that the new regime will abandon its friendly policy toward Israel, and will promote Shariah Law which forbids Christian participation in government. (Coptic Christians form 10% of Egypt's population, and were protected against Islamist fanatics under the now-deposed and disgraced Mubarak. He and his family now face charges that could jail them for life. Why didn't the US or some other Arab nation accept them as refugees when they resigned? What signal does this give to other beleaguered leaders?)

3. Syria is killing, imprisoning and torturing its subjects on a scale reminiscent of the old, bad Assad, who was, you might recall, the mass-murdering father of the good, reformist Assad.

4. The Libyan non-war drags on and Gadafhi, financed, 'tis said, by vast gold holdings, remains in power. Libyan light crude production is down, but not out—yet, but WTI, which spiked from $86 to as high as $114 when the Libyan crisis erupted remains near $100, while Brent, which spiked from $105 to $125 remains at $112. The fear premium in oil is a new tax on the struggling global economy.

5. In Bahrain, the benign Khalifa regime, though Sunni, has ruled an overwhelmingly Shia ministate for more than a century. It has been one of the most liberal of the Arab states—a sharp contrast to Saudi Arabia. Iran has long coveted it, and its radical imams have been spewing their venom on Bahraini TV for years. Led by Saudi Arabia, the Gulf Cooperation Council (GCC) has moved in troops to quell the protests that strangled the city center. The state of emergency is due to end next week, but at least some of those troops will stay for an indefinite period.

6. Yemen is in a state of civil war. Its leader, Abdullah Saleh, one of the US's crucial Mideast allies, has been in power since 1990. He promised to depart once the demonstrations and fi ghting stop, but last weekend he not only refused to sign an exit deal negotiated by the GCC, but his henchmen locked up the delegates for several hours. It is unclear who—or what—will succeed him. It is, however, abundantly clear that Al Qaeda of the Arabian Peninsula, which is headquartered somewhere in the Yemeni desert, will be a big winner from the current chaos. Anwar al-Awlaki, the US-born internet-smart revolutionary who was counselor to the Fort Hood assassin and the Christmas Day would-be bomber, may eventually move to the global leadership of Al Qaeda; all it will take will be one more spectacular success on US soil to make him Osama II.

7. Saudi Arabia has responded to the revolutionary situation by lavishing more than $125 billion on its inhabitants. The Kingdom's accounting practices apply the costs of governing to receipts on oil sales. This suggests that the "ideal oil price" of $70-$80-per-barrel cited by the Saudi Oil Minister last year has to be raised to the $85-$95 range—the price of peace in the most crucial Mideast state.

The optimism of winter that was felt by equity investors and young, liberal Arabs is beginning to unravel, and the risk level in a crucial section of the world will remain elevated.

Lastly, why commodity-driven inflation will stick:

Most economists deride the possibility of commodity-driven inflation, noting that in the 1970s, commodity price boosts were passed through to the broad economy through outsized union wage boosts, and today’s heavy overburden of unused capacity in leading Western economies would rule out wage pressures.

Although the US experience of unionization over the past four decades does not apply to much of the Eurozone, it is instructive: today, government employee membership in the AFL-CIO greatly exceeds private sector union membership.

This time, if commodity inflation is to work its way into prices of manufactured goods within the OECD, it must come mostly from the new global pricesetters in Asia.

These nations are experiencing serious food and, to a lesser extent, fuel infl ation, and their Consumer Price Indices are heavily food-weighted.

Example: Food has a 35% weight in Chinese CPI, and that powerhouse has suddenly become the global leader in labor unrest that triggers large wage increases. Truckers have been shutting down Chinese ports, demanding price increases to cover fuel inflation. China's export prices have been rising for months—both as higher prices within China and because of the slowly strengthening yuan.

We consider it likely that food inflation will prove to be more pernicious and durable this time than in the Seventies.

Why?

Because, back then, food shortages generating food inflation were almost entirely caused by weather or crop diseases. Today, we still have problems with weather disruptions in key grain-growing regions, but pesticides and herbicides have dramatically reduced crop losses of earlier times. However, we now have man-made assaults on food supplies, and they have every indication of being both dangerous and durable. Politicians cloaking their personal political greed in green garb could easily create food shortages of Biblical proportions.